International Trade
ECON8069 - Lecture 12
Australian National University
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Trade
Comparative Advantage
Modelling Trade - Exports, Imports, and Intervention
Free Trade - Pros and Cons
Textbook: Chapter 8
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Comparative Advantage
Absolute Advantage
A situation where one country can produce a good/service at lower
physical cost (labour, capital, etc.) than another country.
Comparative Advantage
A situation where one country can produce a good/service at a lower
opportunity cost than another country.
Important - Every country has Comparative Advantage in something.
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Comparative Advantage - Example
Assume:
There are only two countries (AUS and FOR)
Only two goods are produced (Wheat and Toys)
Constant returns-to-scale within country
Hours needed per unit
Australia Foreign
Wheat (tonnes) 30 60
Toys (1000’s) 5 8
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Comparative Advantage - Example
Hours needed per unit
Australia Foreign
Wheat (tonnes) 30 60
Toys (1000’s) 5 8
For Australia (without trade):
Opportunity Cost of Wheat is 6 units of Toys
Opportunity Cost of Toys is 1/6 units of Wheat
For Foreign:
Opportunity Cost of Wheat is 7.5 units of Toys
Opportunity Cost of Toys is 2/15 units of Wheat
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Comparative Advantage - Example
For Australia (without trade):
Opportunity Cost of Wheat is 6 units of Toys
Opportunity Cost of Toys is 1/6 units of Wheat
For Foreign:
Opportunity Cost of Wheat is 7.5 units of Toys
Opportunity Cost of Toys is 2/15 units of Wheat
Australia has Comparative Advantage in Wheat (lower Opportunity
cost)
Foreign has Comparative Advantage in Toys (lower Opportunity cost)
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Production Possibility Curve without Trade
Suppose:
Australia has 15,000 hours of labour:
Could produce up to 500 units of Wheat, or
could produce up to 3000 units of Toys.
Foreign has 48,000 hours of labour:
Could produce up to 800 units of Wheat, or
could produce up to 6000 units of Toys.
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Gains from Trade
Each country expands what it can consume by exporting the good it
has a comparative advantage in, and importing the other good.
An example production change; world production of both goods
increases.
Change in Wheat Change in Toys
AUS +6 -36
FOR -5 +37.5
WORLD +1 +1.5
The PPF with trade.
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Reasons for Comparative Advantage
1. Climate: Impacts agricultural production, tourism
2. Natural Resources: Oil in OPEC, gold in Australia, not Singapore
3. Technology/Human Capital: E.g. Growth of Australian wine industry,
manufacturer of high-speed ferries, exporter of education.
4. Capital-Labour Ratio: Capital abundant US and Europe produce
aeroplanes; Labour abundant Myanmar produces clothing and toys.
Comparative Advantage changes over time due to changes in these
factors. We observe dynamic comparative advantage.
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Wage Costs
Let the hourly wage be w in Australia, and w f in Foreign.
Monetary Cost per unit of production
Australia Foreign
Wheat (tonnes) 30w 60w f
Toys (1000’s) 5w 8w f
A Lowest Cost Producer (LCP) of a good is a county which can
produce each unit of the good at the lowest monetary cost.
The LCP will depend on the relative wages in each country.
Competition means goods will only be produced by a LCP.
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Lowest Cost Producer - Example
AUS is a LCP of Wheat iff 30w ≤ 60w f . That is, w/w f ≤ 2.
AUS is a LCP of Toys iff 5w ≤ 8w f . That is, w/w f ≤ 1.6.
Situations:
I. If w/w f < 1.6, then AUS is unique LCP of both goods.
II. If 1.6 ≤ w/w f ≤ 2, then AUS is a LCP of Wheat, and FOR is a LCP
of Toys.
III. If w/w f > 2, then FOR is LCP of both goods.
Situations I and III can be ruled out in equilibrium as one country is
producing no goods. Equilibrium relative wages are 1.6 ≤ w/w f ≤ 2.
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Production and Equilibrium Wages
Given Equilibrium Relative Wages, there are three cases:
X. If w/w f = 1.6, both are LCP of Toys, AUS is unique LCP of Wheat.
AUS produces Wheat and Toys.
FOR produces only Toys.
Y. If 1.6 < w/w f < 2, FOR is LCP of Toys, AUS is LCP of Wheat.
AUS produces only Wheat.
FOR produces only Toys.
Z. If w/w f = 2, FOR is unique LCP of Toys, both are LCP of Wheat.
AUS produces only Wheat.
FOR produces Wheat and Toys.
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Production and Equilibrium Wages
Regardless of wages, AUS produces and exports Wheat to buy Toys;
FOR produces and exports Toys to buy beef.
The particular equilibrium wage will depend on consumer preferences.
E.g. if consumer preference on the world PPF is in region X , then
w/w f must be 1.6.
A high productivity country pays higher wages; low productivity
countries compete by paying lower wages.
Wage differences are limited by differences in labour productivity.
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Welfare without Trade - Recall
Consumer Surplus is Value to Consumers of their consumption minus
their expenditure
The gap between the MB/Demand curve and the price paid, up to the
quantity consumed
Producer Surplus is Revenue from sales minus the cost of production
The gap between the MC/Supply curve and the price paid, up to the
quantity sold
Government Revenue/Spending may also feature into Total Surplus,
if the government intervenes in the market.
Deadweight Loss is the difference between the maximum possible
total surplus, and the total surplus that is actually realised.
The ‘without trade’ equilibrium is called the autarky equilibrium.
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‘Small’ Economies
An economy is a ‘small economy’ if it is small in size relative to the
world market.
Small economies are price-takers in the world market. There is a world
price, and any amount of goods can be bought and sold at that price.
Australia is (usually) a ‘small’ economy.
Most of the insights here also hold for ‘large’ economies, like China
and the USA.
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Exporting Country
If world price pw is greater than the autarky domestic price, then the
country wants to export goods.
This is caused by having a comparative advantage in production of
that good.
Domestically, exporting will cause the price to increase, the domestic
qd to fall, and domestic qs to increase.
Domestically, this sees an increase in Producer Surplus, a fall in
Consumer Surplus, and an increase in Total Surplus.
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Importing Country
If world price pw is less than the autarky domestic price, then the
country wants to import goods.
This is caused as foreign countries have a comparative advantage in
production of that good.
Domestically, importing will cause the price to fall, the domestic qd to
rise, and domestic qs to fall.
Domestically, this sees a decrease in Producer Surplus, an increase in
Consumer Surplus, and an increase in Total Surplus.
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Opposition to Trade
Given that both imports and exports result in increased total surplus,
why do we see aversion to imports?
Gains can be large, but are widely dispersed among many consumers.
Each consumer benefits only a little.
Losses are smaller, but concentrated among a small number of
producers. Each producer is harmed substantially.
This leads to concentrated and vociferous opposition to imports.
Sometimes see opposition to exports. E.g. Australian gas exports.
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Government Intervention
Imports duties: a tax on imports
Price paid by consumers and domestic producers increases.
Domestic qs increases, while domestic qd falls.
Inefficient as not using the lowest cost producer (LCP), and not
consuming where the MC for the LCP equals the MB to consumers.
Government Revenue exists
Import Quotas: a direct limit on the number of imports
Similar to import duties
But, no government revenue
Benefit goes instead to foreign producers
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Case Study - Transport Costs
Recently in Australia, domestic prices for LPG (gas) have increased.
This was blamed on increased export infrastructure. Is this reason
feasible?
The effect of transport costs of export goods is to create a gap
between the world price pw , and the price received by exporters pex .
Let the world price for LPG (gas) be $175 per unit, and the autarky
equilibirum price in Australia be $100.
What happens in this market if transport costs are $100 per unit?
What happens to domestic prices in Australia if transport costs are
reduced to only $25 per unit?
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Economic Arguments for International Trade
Voluntary exchange is mutually advantageous
Exploit comparative advantage and specialisation
Exploit economies of scale
Benefits from increased competition
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Arguments for Trade Barriers
Infant Industry Argument
Young industries need to be protected until they are, later, able to
compete
Infant industries rarely ‘grow-up’, and are supported forever
Opinion: Somewhat reasonable in principle; works poorly in practice
Thwart Cheap Foreign Labour
Ignores gains from trade due to comparative advantage
Foreign labour is cheaper per labour, not per output
Opinion: Poor argument
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Arguments for Trade Barriers
National Security Argument
Protect industries which produce strategic materials
Often other means exist to achieve these objectives, e.g. stockpile
materials
Can backfire; interdependence reduces risk of war
Opinion: Potentially reasonable when other means do not exist
Retaliation Argument
E.g. US puts tariffs on Chinese imports, China threatens or retaliates
by restricting US imports into China
Harms Chinese consumers as well as US producers
Threatens escalation of trade war, or further retaliation
Opinion: Very tricky. Best to threaten retaliation and hope that stops
initial tariffs.
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Arguments for Trade Barriers
Redistribution Argument
For equity/political reasons, want to protect Australian workers in weak
industries
Other methods (e.g. production subsidies) usually cause smaller DWL
in practice
Opinion: In the long-run better to re-train workers
Environmental/Labour Standards Argument
Restrict imports from countries with weak environmental and labour
standards
Designed to encourage better environmental/labour standards in those
countries
Concern: Usually standards are weak because the country is poor.
Trade helps development.
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Arguments for Trade Barriers
Foreign Subsidies Argument
Foreign governments subsidise their industries, so we need to as well
Foreign subsidies lower the world price; we can just enjoy the lower
world price
AUS subsidies are paid by AUS taxpayers
Opinion: Better to enjoy the benefits of other counties subsidies
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Finale
“The purpose of studying economics is not to acquire a set of ready-made
answers to economic questions, but to learn how to avoid being deceived
by economists.” - Joan Robinson
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